Credit and Collection

Functions of Credit
Module 3
FUNCTIONS OF CREDIT

At the end of the lesson, the student should be able to:

1. explain the general functions of credit.

2. cite the advantages and disadvantages of credit.
3. discuss the importance of credit to the economy.
4. identify and classify the of types of credit.

When the use of money was introduced, credit also came into existence.
Credit is created when one party (a person, a firm, or an institution) lends
money to another party, the borrower. It is generally understood that credit is
extended to borrowers at a certain interest rate.

General Functions of Credit

1. It makes possible the formation of large enterprises that result in economies
of scale, which in turn will reduce the cost of production and lower prices (from
wholesale to retail levels).

Lower prices will make it possible for a much larger portion of the
population to enjoy the benefits of affordable products, thus improving the
quality of life of everyone.
This benefit refers to the manufacturing side. The larger the enterprise, the
more economy of scale is achieved.

2. Credit brings to the economy the expansion of the purchasing power of the
consumers.

Diagram 1

credit provided
expands consumer
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Functions of Credit
demand

MANUFACTURER WHOLESALER RETAILER CONSUMER

When the purchasing power of the consumers (at the right rightmost part
of the diagram) is expanded, this increases demand and actual consumption,
which in turn will require higher production. A somewhat similar situation
applies in economics, an expansion in purchasing power through credit
availabiltility, is ‘ demand-side ’ economics. It energizes economic activity
towards the whole distribution system.
An expansion is investment in the manufacturing sector brought about the
use of credit, makes new innovative and cheaper products available, also
energizing economic activities from the left side of the above diagram towards
the right. This is ‘supply side’ econmics.

3. Credit saves time and transactional expenses, which makes the process -
in the entrire distribution system, from manufacturer to consumers, more
convenient and efficient.

Savings in time and transaction costs will result in higher margins for all
the components of the distribution system.

4. Credit has the multiplier effect.

Multiplier effect is another concept in economics. Large-scale credit that

results in the creation of large enterprises will necessarily empower new, or
enhance old, linkages. A business enterprise is linked to other enterprises
have to travel and provide entertainment to clients. Advertising contracts must
be obtained. The linkages are: production (factory), transport enterprises,
travel companies, and hotels and restaurants, advertising companies, among
many more others.
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Functions of Credit
ADVANTAGES AND DISADVANTAGES OF CREDIT

Advantages of Credit
1. Credit in its nature, plays a vital and major part in any economy.
It speeds up the transfer of goods from producers to consumers. Imagine if
one has always to have cash to be able to buy goods and services. Through
credit, one has only to pay a small amount as a down payment and the
balance through installment.

2. Credit also makes capital more productive.

Excess or unused capital may be deposited in a bank earning for the
depositor interest as compensation for the transfer of capital. These deposits
are then combined together and in turn lent to merchants or manufacturers
who can use the money productively. Thus, credit makes capital more
productive.

3. Credit does not only benefit the consumer but the entire business industry
as well.
The retailer gets his goods from the manufacturer on credit which it turn
gets the raw materials from their suppliers also on credit. These suppliers
borrow their capital from banks whose money comes from the creditors or
depositors.

4. A great advantage of credit in business is convenience.

It becomes a simple matter to transfer huge amounts of money through
credit instruments, even overseas.

5. Credit may be secured to establish an enterprise and finance in its various

transactions, adding to its growth.
When done across sectors, this process accelerates capital formation,
employment generation, and therefore, contributes not only to the overall
economic development but also to the enhancement of social responsibility.
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Functions of Credit

Disadvantages of Credit

1. Massive defaults across sectors trigger credit controls, making it harder to

secure the needed liquidity to continue business operations.

2. Credit encourages over-zealous and aggressive entrepreneurs to

over-expand unreasonably.

Failure to generate the expected resources can only cause reverses in

business which could affect the nation’s economy.Some businessmen abuse
the credit extension privileges afforded them by banks which sometimes end to
the disadvantage of the entrepreneur. Often this is caused by failure to make
an adequate study of a contemplated project.

3. Credit likewise contributes to the extravagance and carelessness on the

part of the borrowers.

4. In a marketing oriented company, the desire to push sales might lead to

extension of credit to unworthy or risky parties who might end up to be bad
debtors after all who will cause the collapse of the company.

5. Over-extension of credit could create an imbalance in the financial system.

It could cause liquidity problems, especially if credit is extended to favored
individuals who have more C’s inclined towards Connections than any of the
C’s of credit.

CLASSIFICATIONS OF CREDIT
In her book Introduction to Philippine Money, Credit and Banking, Ruby F.
Alminar Mutya, identified the different classifications of credit such as:
according to type of user, according to purpose, according to maturity and
according to form.
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Functions of Credit

According to Type of User

Consumer Credit
This is a credit used by individuals to help finance or refinance the
purchase of commodities for personal consumption.
The two basic categories of consumer credit are open-end and closed-end
credit (debt.org.).
 Open-end credit, better known as revolving credit, can be used
repeatedly for purchases that will be paid back monthly, though paying
the full amount due every month is not required.
 Closed-end credit is used to finance a specific purpose for a specific
period of time. They also are called installment loans because
consumers are required to follow a regular payment schedule (usually
monthly) that includes interest charges, until the principal is paid off.

Commercial Credit
Commercial credit is extended by one businessman to another
businessman. The creditor and debtor are both businessmen. Objects of credit
are merchandise or goods which are delivered on consignment basis or under
the credit term.

Commercial Bank Credit

In this kind of credit, the creditor is a commercial bank while the debtor can
be a business firm or private businessman. The debtor may consider
commercial bank for loans in order to assist him in business operations.

According to Purpose
Investment Credit
Investment credit is extended by banks for company who intends to
purchase fixed assets - land, building, equipment for business use.
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Functions of Credit
Agricultural Credit
This is a loan extended intended for the acquisition of fertilizers, pesticides,
seedlings, transportation of agricultural products and farm improvements.
Debtors are farm breeders and creditors are rural banks. These loans can be
on a short-term or long-term maturity.

Export Credit
Export credit uses “letter of credit” as a tool for financing international trade.
This letter of credit or LC is issued by the importer’s bank, it guarantees
payment to the exporter up to some specified amount of money. In this
procedure, the exporter is protected by a substitution of the bank’s good faith
and credit for that of the importer. There are two general types:
 the import letter of credit which requires payment be made in the
importer’s currency; and
 the export letter of credit which requires that it be made in exporter’s
currency.
Parties to this loan are the
 importer
 importer’s bank
 exporter, and
 exporters bank.

Real Estate Loan

Real estate loan is intended for the purchase of house and lot, for house
construction, or improvement.

Industrial Credit
This is intended to finance industries like logging, fishing, mining, quarrying,
and the like.

According to Maturity
Short-term loans
Short-terrm loans are payable within a period of one year.
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Functions of Credit

Intermediate term
Intermediate term or medium terrm loans are payable for a period of one to
five years.

Long-term loans
Long-term loans are payable for more than five years.

According to Form of Credit

Cash form of credit
Merchandise form of credit
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Functions of Credit
References and Supplementary Materials
Books and Journals
1. Mutya, Ruby F. Alminar-Mutya, 2017. Introduction to Philippine Money,
Credit and Banking. Second Edition. Mandaluyong City
2. Briones, Jose Glenn Sr., 2015. Credit and Collection Management
Made Easy for Filipino College Students. Mandaluyong City, National Book
Store, Inc.

Online Supplementary Reading Materials

1. The Importance of Managing Money
http://mtstcil.org/skills/budget-12.html21November2019
2. Types of Consumer Credit & Loans
https://www.debt.org/credit/loans/23November2019

Online Instructional Videos

Credit Banking: Meaning, Functions and Purpose of Credit Banking
http://www.yourarticlelibrary.com/banking/credit-banking-meaning-func
tions-and-purpose-of-credit-banking/37871

Pros and Cons of Bank Loans

https://www.youtube.com/watch?v=xjM_5l-8Nhk